United States Business in Today's Economy Dennis O'Toole Virginia Commonwealth University Richmond, Virginia

In the American economic system, business is the principal institution by which we allocate resources and produce goods and services. In the United States, 20 million business firms provide final goods and services to 102 million households.

In market-based economic systems such as ours, household demand and business firms' profit expectations determine the goods and services. Scarcity of resources requires households to choose which goods and services they will buy, and business firms to choose which goods and services to produce and how to produce them.

Business firms seek to maximize profits (or minimize losses). New businesses entering the market in pursuit of profit will tend to expand the production of goods and services, and to reduce prices. Economic losses will tend to reduce the quantity of goods and services provided by business firms, and to raise prices. In the long run, firms that do not cover all their costs and earn a profit will shut down.

In pursuit of their goals in production and profit, business firms purchase factors of production -- inputs such as raw materials, labor, capital, and entrepreneurial ability -- from households. The return to households for their factors of production is called income (rent, wages, interest, and profit). Business firms use factors of production to the point that the extra revenue received from the factor is equal to the extra cost of the factor. For instance, if hiring an additional worker will cost the firm $20 in a given time period, the firm will hire the worker as long as the additional worker can add $20 or more of additional revenue.

Households use the income earned from business firms to buy the goods and services that firms produce. Thus, people in households with high incomes -- e.g., movie stars, medical doctors, and professional basketball players -- can buy more goods and services than people in households with low incomes, such as workers who serve fries at fast-food restaurants.

Major changes have occurred in the kinds of goods and services U.S. business firms produce and in the mix of the factors of production used to produce them. In the past 20 years, many business firms have:

1. shifted their emphasis away from manufacturing and toward information technology; and

2. shifted toward more globalization.

The shift from manufacturing to information technology

In 1977 a small California firm called Apple produced the first commercially successful personal computer. Initially only a few firms produced personal computers, but as profits rose new firms entered the industry. As the industry grew, more and more factors of production were used to produce computer hardware and software while fewer factors of production were used in traditional manufacturing industries. In 1977, manufacturing accounted for 23 percent of gross domestic product (GDP) in the U.S. By 1994, manufacturing had fallen to 17 percent of GDP.

Forbes' annual list of the 10 richest people in America reflects this trend. When the magazine published its first list in 1918, eight of the 10 richest Americans earned their money either in the manufacturing or oil industries. Oil baron John D. Rockefeller headed the list with a net worth of $12.8 billion. (The figures have been adjusted for inflation.) In 1997 Bill Gates (one of the founders of Microsoft Corporation and currently chairman of the board) topped the Forbes list with an estimated net worth of $36.4 billion. Three other people on last year's list were in computers and information technology. None of the 10 richest Americans amassed their wealth from manufacturing.

This is no surprise. Goods and services such as fax machines, cellular phones, personal computers, modems, and the Internet may have been virtually nonexistent 20 years ago, but they have grown tremendously in importance in the 1990s. For instance, in 1991 Americans owned 4.2 million cell phones and 24 million personal computers; by 1997 Americans owned 25.8 million cell phones and 38.2 million personal computers. Profits generated by business firms in these industries -- those firms that satisfy household demand at the lowest cost -- will allocate more goods and services into the information technology area.

Consumer demand also can shift away from certain products. Firms producing these products will then experience losses and eventually go out of business. For example, Union Envelope -- a firm in Richmond, Va., that made standard-size envelopes -- closed in 1994 after 91 years in business and laid off 202 workers. Fax machines, electronic mail (e-mail), and higher postal rates had reduced the use of Union's product. The demand for envelopes had dropped because of new substitutes.

Both business firms and households are driving the move toward information technology. Business fixed investment has risen from 12.3 percent of GDP in 1991 to 15.5 percent of GDP in 1997. A surge in capital investment that began early in 1993 has since strengthened. From 1993 to 1997, purchases of computer and telecommunications equipment have risen by more than 14 percent annually in nominal terms, and by 25 percent in real terms. (In general, prices for most of this equipment decreased over this time period.)

This huge increase in business investment during the 1990s has implications for productivity, which is the output per worker in some given time. Increased productivity enables a business firm to:

1. increase its profit;

2. pay workers higher levels of compensation; and/or

3. lower prices.

Over the long term, the pace of labor productivity gains determines the rate of growth of profit and the rate of growth in workers' real compensation. In 1997 productivity grew at about a 2.2 percent rate, twice the average annual rate during the 1970s and 1980s.

The shift toward globalization

The role of exports and imports in the U.S. economy has increased substantially over the years. In 1952 exports and imports accounted for about eight percent of our GDP. In 1977 they accounted for about 17 percent, and in 1997 they accounted for about 26 percent of GDP.

The opening up of markets around the world has increased demand for American-made products such as movies, jeans, and private jet planes. But this globalization has also brought many American companies intense competition, prompting many American firms to build or buy plants in foreign countries (where wages and raw material costs are cheaper) in order to remain competitive. It may seem that American jobs would be lost as a result. But when households in other countries earn higher incomes, people in those countries can buy more American-made goods and services. The net effect on U.S. employment has been slightly positive.

Another aspect of the shift to globalization and the growth of exports and imports is that American companies may have become more susceptible to economic shocks in other parts of the world. In the summer and fall of 1997, financial institutions and stock exchanges in Thailand, Indonesia, the Philippines, and Malaysia had some major problems. These four countries accounted for about four percent of U.S. exports in 1996. However, financial institutions and stock exchanges in Hong Kong, South Korea, Singapore, and Taiwan were also affected by the end of 1997. These four countries accounted for an additional 12 percent of U.S. exports in 1996. Thus, American companies that have focused their efforts in this part of the world may experience reduced demand for their exports in 1998. This example also illustrates the so-called contagion effect, where a weakness in one economy can spread to others as investors perceive, correctly or not, similar vulnerabilities.

The shift to globalization has opened new markets to American business firms, fostered greater specialization in the production of a wide array of goods and services, and held down costs and enhanced efficiencies. But it has also increased interdependence, making business firms subject to new risks as well as new opportunities.

Conclusion

American business firms produce the goods and services that meet household demand, as well as the incomes that fuel demand. As people demand fewer envelopes and more e-mail, business firms will produce more e-mail (because it is more profitable) and fewer envelopes (because they are less profitable). Household demand for computer technology and imports has increased recently and -- in other parts of the world -- U.S. exports see growing demand. As profits in these areas rise, business firms purchase more raw material, labor, capital, and entrepreneurial ability -- at the lowest possible cost -- to compete with business firms around the world. This ongoing process of substituting low-price inputs for high-price factors of production will continue to raise household incomes and standards of living not only in the United States but overseas as well.

Dennis O'Toole is an associate professor of economics at Virginia Commonwealth University